2023-04-11 04:55:42 ET
Summary
- iBonds investment grade corporate term ETFs provide multiple advantages for investors.
- Most households lack appropriate corporate debt holdings. These ETFs are strategic and accessible to remedy position deficiencies.
- Investment grade securities have theoretically less risk, augment with high-yield holdings to increase returns.
Thesis
Investors should consider building positions in debt securities. Corporate debt instruments like iShares iBonds Dec 2023 Term Corporate ETF ( IBDO ), ( IBDP ), ( IBDQ ), ( IBDR ), ( IBDS ), ( IBDT ) as managed by BlackRock ( BLK ) can be utilized in a myriad of advantageous ways. These term ETFs can ease investor fears through risk mitigating techniques like diversification, higher priority securities, higher credit ratings, providing monthly cash flows, and the held to maturity features to combat interest rate risks. They also provide fair fees, lower capital requirements, and added liquidity through the ETF vehicles. Currently, debt returns are projected at a higher rate and it is a good time for many investors whose investment strategies should align with a larger debt position to move into these positions. These financial instruments can also be utilized in conjunction with other positions for maximum returns and broader benefits in a highly customizable way.
Quick Recap: Household Portfolios And Fixed Income Securities
One of the objectives of the prior referenced article was to convey that many investors likely lack an appropriate position size in their portfolios specifically regarding corporate debt securities. It was also articulated that the current environment provides a much more appetizing way to establish or reinforce a position in corporate debt since the return yields are much higher than the past decade.
It was suggested that the largest barriers for fixed income securities is the lack of education, access to the securities themselves, liquidity, associated fees, larger requirement of investment capital, and poor historical returns over the past decade compared to other assets.
Investors that should be interested in fixed income instruments are those that seek repeating income streams with lower risk and volatility, don't mind smaller returns in respect to equities (theoretically), and those that are less prone to liquidity risks.
The Case For An iBonds Corporate Term ETF
Bond ETFs can be of use to investors and the focus of this article is on the BlackRock iBonds Term Corporate ETF series (not to be confused with the High Yield Corporate ETF series) as there are some benefits to this instrument that may be suitable for investors with certain needs. The structure and design of these products can help mitigate a lot of the risks, capital requirement barriers and educational barriers of buying instruments like this that investors face.
iBonds ETFs combine the benefits of multiple other products for investors as referenced in the figure below. They offer a diversified bond portfolio (mitigate credit risk), offer multiple debt instruments (treasury, municipal, IG corporate, and HY corporate) that give monthly distributions (income stream), through an ETF (better costs, access, and liquidity), with a set maturity date at the end of a designated period (mitigate interest rate risk via hold-to-maturity option).
Why Corporate iBonds (Investment Grade, IG)
Investment grade debt securities originate from higher credit rated firms which theoretically have lower risk accompanied by lesser returns. Investment grade means that the issuing firm has a BBB-/Baa3 credit rating and above according to firms Moody's and Standard & Poor's, respectively.
This is in contrast to high yield securities that have lower credit ratings signaling higher risks resulting in higher return expectations. The strategy for this class of ETF specifically is to utilize bond ladders to maximize returns and decrease risks over a set period of time. The IG iBonds offer diversification, defined maturity, regular income distribution, and a very reasonable fee of 0.10%. These are powerful characteristics when appropriately aligned in a portfolio.
The figure below represents an iBond ladder (unevenly distributed) with a holding maturing every year between 2023 and 2028. Attention should be brought to the annually decreasing YTM with a high of 5.49% in 2023 and a low of 4.6% in 2027. This is likely due to the high short-term uncertainties that markets are pricing in. This example has a pre-tax/post-fees weighted YTM of 4.93% and a total holding of over 3,000 investment grade bonds.
The ETFs will mature on a yearly basis which allows for reinvestment decisions at that time period of new information. This does not include exchange fees/commissions as they vary by exchange and will have a significant impact on the yield.
Risks
Country Risk
The combination of these holdings is distributed across geography with a heavy emphasis in the U.S. Notice how the distribution is primarily developed markets which helps to mitigate country specific risks while benefiting investors through more diversification. Being predominantly in the U.S. is also a positive considering the strength of U.S. debt markets in comparison to other countries.
Sector Risk
The sector distribution is allocated more heavily towards certain sectors that tend to favor investment grade credit ratings though there is a broader diversification aspect benefiting investors. For this specific distribution, there is a 23% weighting in the banking sector. With the recent banking concerns augmented by increased pressure from higher interest rates, it is understandable that a healthy caution in the banking sector may be warranted. Linked is also a Blackrock memo highlighting all of their funds exposures to Credit Suisse ( CS ), UBS ( UBS ), Silicon Valley Bank, and Signature Bank ( OTC:SBNY ). It is important for investors who are seeking less risk to diversify across sectors as it helps to mitigate losses in the underlying securities returns.
Credit Risk
Credit risk is a risk referring to the inability for the company to fulfill their payment obligation to investors. Fortunately, debt investors are a higher priority than equity investors and holding through a diversified portfolio managed through an institutional manager decreases the risk of loss substantially. The credit quality distribution below is aligned with the investment grade credit goal of being higher grade credit quality companies. These higher credit ratings provide a lesser returns for investors in respect to high yield credit rated companies though it is important to diversify credit quality across your portfolio which can be done by adding varying grade debt as well. Having a portfolio of strictly investment grade instruments offers low-variance benefits, though mixing in different credit rated holdings can be a good addition if positioned appropriately.
Liquidity Risk
Liquidity risk from an investor perspective is the risk that immediate cash is needed and the investors can't recover the full value of their holding within a short-term time period. This is a common issue for holding debt instruments in the sense that debt holders may need to sell at a discount to liquidate their holdings. Fortunately, ETFs allow for more liquidity though the price action may not be favorable for the investor at the time they need to sell. One way to mitigate this risk is to ensure that liquidity requirements are met elsewhere and that the security can be held to maturity.
Interest Rate Risk
Interest rate risk is the risk that an increase in interest rates have on debt instruments due to an inverse relationship ultimately decreasing the value at that time. This risk can also be mitigated by holding the debt instrument to maturity. However, it is important to note that the inverse is true as well, if interest rates decrease then the value of the debt instrument will increase and an investor could sell their holdings earlier at a premium to their cost basis. Thus, the management of interest rate risk now has three exit opportunities for iBonds which are 1) price declines, sell at loss 2) price increases, sell at gain 3) do nothing, bonds mature and investors collects principal at that time. The third option is what separates these types of products from other bond ETFs in the form of an advantage for certain portfolios.
Fees/Costs/Taxation
The fees for iBonds Term Corporate ETFs are 0.10%. Creating a screener on Seeking Alpha allowed the filtering of 62 Corporate Bond and Target Maturity ETFs with the results of their expense ratios in the figure below. This shows that the iBonds Term Corporate ETFs are below the median 0f 0.12% and well above the very competitive 0.03%. The fees impact investor yields, so it is critical to find the appropriate tool for the desired strategy.
Trading costs and commissions from brokerage firms and exchanges can severely deteriorate the yield to maturity of these holdings. Many firms offer no-commission ETF transactions, which should be a consideration as to the investment vehicle utilized.
The returns on these ETFs are taxed as ordinary income which places them at a disadvantage to other assets like qualified dividend equities, treasury securities, and municipal bonds. The figure below shows what the post-tax yield to maturity would be based on the sample calculation above for a staggered bond ladder. As an example, if an investor was at the 22% tax bracket and they achieved a pre-tax 4.93% yield, then they could expect a post-tax return of 3.84% (excluding any other costs). A strategy that could be utilized is to hold these positions in tax advantaged accounts which would allow for greater compounding over time.
Now For Some Fun - Combining Investment Grade and High Yield Scenario
The investment grade ((IG)) and high yield ((HY)) ETFs can also be combined to further alter volatility while increasing return expectation.
An example of holding investment grade corporate term bond ETFs in conjunction with high yield corporate term bond ETFs is shown below ( IBHC )( IBHD )( IBHE )( IBHF )( IBHG )( IBHH )( IBHI ) . For this scenario, the time period was selected between 2023 and 2028 maturities. The scenario weighted YTM was 6.39% and combined to a total of over 4,300 bond holdings.
The weighting was unevenly distributed with an emphasis on approximately maintaining a 50-50 split along with an approximately 14% to 20% of capital maturing each year across the laddering period. Investors can utilize data like this to optimize their own constraints and strategies as this scenario is just an example.
To illustrate the point of a diversified credit quality, the figure below shows the credit distribution of the combined investment grade and high yield portfolio in this scenario.
The figure below represents a healthier sector distribution when combining the investment grade and high yield instruments as done in this scenario compared to products held in isolation.
Conclusion
The intent of this article was to identify another set of financial instruments (investment grade corporate debt term ETFs) that could be utilized to strategically allocate investment positions seeking a balance between returns and risks. We also presented two scenarios, one of an investment grade corporate term ETF ladder by itself, and another of a combined high yield/investment grade corporate term ETF ladder. The intent was to demonstrate how customizable and beneficial the implementation of these products can be.
Currently, debt returns are projected at a higher rate and it is a good time for many investors whose investment strategies should align with a larger debt position to move into these positions. The benefit of these IG corporate term ETFs is that the funds diversify holdings well, allows better access and liquidity to debt instruments, have fair fees that are lower compared to their peer group median, have monthly cash flows, lower capital requirements, and a set maturity date. Overall, the ETF design provides a good balance between risk mitigation and reward expectation while adding different types of debt holdings to a portfolio could be beneficial.
For further details see:
Why You Should Be Interested In iBonds Investment Grade Corporate Term ETFs